Milton Friedman Would Have Supported QE2

The debate over what Milton Friedman would say about QE2 can now be closed. Below is a Q&A with Milton Friedman following a speech he delivered in 2000. In this excerpted exchange with David Laidler, we learn that Friedman’s prescription for Japan at that time is almost identical to what the Fed is doing now with QE2: (my bold below)

David Laidler: Many commentators are claiming that, in Japan, with short interest rates essentially at zero, monetary policy is as expansionary as it can get, but has had no stimulative effect on the economy. Do you have a view on this issue?

Milton Friedman: Yes, indeed. As far as Japan is concerned, the situation is very clear. And it’s a good example. I’m glad you brought it up, because it shows how unreliable interest rates can be as an indicator of appropriate monetary policy.

During the 1970s, you had the bubble period. Monetary growth was very high. There was a so-called speculative bubble in the stock market. In 1989, the Bank of Japan stepped on the brakes very hard and brought money supply down to negative rates for a while. The stock market broke. The economy went into a recession, and it’s been in a state of quasi recession ever since. Monetary growth has been too low. Now, the Bank of Japan’s argument is, “Oh well, we’ve got the interest rate down to zero; what more can we do?”

It’s very simple. They can buy long-term government securities, and they can keep buying them and providing high-powered money until the high powered money starts getting the economy in an expansion. What Japan needs is a more expansive domestic monetary policy.

The Japanese bank has supposedly had, until very recently, a zero interest rate policy. Yet that zero interest rate policy was evidence of an extremely tight monetary policy. Essentially, you had deflation. The real interest rate was positive; it was not negative. What you needed in Japan was more liquidity.

So Milton Friedman said in 2000 that the Bank of Japan should do what the Federal Reserve would be doing 10 years later! In fact, if names, dates, and places were changed in the above excerpt one could get a 2010 Ben Bernanke Q&A. Friedman’s belief that a zero policy interest rate could be contratctionary and thus required the central bank to buy long-term securities shows that he understood unconventional monetary policy long before it was vogue. He truly was a great economist.

Note, though, that his emphasis is still on expanding the monetary base as much as needed to start and maintain an economic expansion. This implies he saw an excess money demand problem in Japan, just as there is one today in the United States. He understood, though, the need to expand the monetary base through purchases of long-term securities rather than short-term ones. This is because short-term securities are close to a perfect substitute for the monetary base at a zero percent policy rate. Swapping perfect substitutes does not change anything in one’s portfolio of assets and therefore has no effect on spending. Thus, Friedman saw the need for purchasing long-term securities, which are not perfect substitutes with the monetary base.

Although Milton Friedman probably would have preferred a rule-based approach to QE2, this excerpt is the smoking gun that ends all debate on whether he would have supported QE2. The case is closed.

Thanks to Doug Irwin for locating this gem.